Activist Investors Get the SEC Muzzle

SAN FRANCISCO -- The Securities and Exchange Commission's recent decision to block shareholders from nominating outside directors has put a damper on an important strategy for institutional investors.

The ruling, which allows companies to bar shareholders from submitting proposals, has sent institutional shareholders scrambling for alternatives. They can petition the SEC to reconsider the decision, negotiate behind the scenes with company boards for more pro-shareholder policies, or publicly confront boards with their demands for change.

Indeed, the SEC's Nov. 28 decision could lead to an unusually contentious season in 2008, according to RiskMetrics.

In recent years, big institutional investors have been diving into corporate governance-styled investments that are typically run by activist investment advisors.

These investments are distinct from many hedge funds by what they exclude: short strategies, arbitrage, leverage and overly hostile tactics, says Andrew Junkin, managing director at Wilshire Associates. "The ones we've evaluated go long only. They are friendly activists who try to engage with management."

And these investments have proven profitable. Junkin estimates that such investments beat the benchmarks of passive investments by 3% to 5% "over a long period of time."

Although such firms have been around for a decade, they're gaining traction among institutional investors.

One is led by former SEC Chairman Richard Breeden, whose corporate governance-style investment company listed assets under management of $770.6 million at the end of September, more than double its holdings in March.

Breeden Capital uses the strategy to wring change from its holdings. It successfully nominated a slate of candidates to the board of H&R Block ( HRB) in 2007. Breeden took over as chairman of HRB's board in November.

At California Public Employees' Retirement System, its shareholder-activist investment strategy has paid higher returns than the benchmark returns of similar, but passive, investments. CalPERS more than doubled its investment in corporate governance funds in mid-2007 to $10 billion, or 5% of its global equity investments. The pension fund manages $250 billion in assets.

"The corporate governance program at CalPERS has been highly successful," Junkin and colleague Michael Schlachter wrote in a consulting capacity in a Sept. 25 letter to the organization's investment committee.

CalPERS, though, stepped up investment in such funds just as the SEC is blocking a key activist strategy with its recent decision.

Under Chairman Christopher Cox, the SEC has rolled back shareholder proxy access rights granted by a court decision in late 2006 that created confusion around proxy disclosure rules. The SEC decision, which went into effect on Thursday, sought to clarify rules before the new proxy season.

Although Cox held out the possibility that the SEC would revisit the policy, don't hold your breath. The commission issued the decision despite an outpouring of opposition from institutional investors and others, including a letter from 39 law professors.

"We have low expectations" that the SEC would reopen the issue "in the foreseeable future," Ryan Francis, communications director at the National Conference on Public Employees' Retirement Systems, said this week. "They don't seem ... to be interested in investor rights at this point."

However, NCPERS executive director Hank Kim said the SEC's decision is a "speed bump" that will not discourage pension systems from governance activism.

And CalPERS spokesman Clark McKinley said CalPERS is looking for the SEC to take up that issue again in 2008. "It's of great importance to us."

Cox indicated his intention "to continue the discussion of proxy access in 2008," Carol Nolan Drake, corporate governance manager for the Ohio Public Employees Retirement System, wrote in an email response to questions from TheStreet.com. "We are hopeful that the SEC moves forward on this issue."

With proxy access possibly diminished, "institutional investors may want to elevate their engagement with individual corporations, their boards of directors and/or CEOs," she added.

"Our sense is that there may be more proposed shareholder resolutions offered in the coming proxy season ... seeking to nominate a director(s) to the corporation's board," she wrote.

Yet, because of the SEC's decision, denying shareholder access to the ballot is now an option for boards that insulate themselves from the interests of its owners.

Rather than rubber-stamping directors with connections to company management, shareholders want to see "that we're adequately represented" on the board, McKinley asserted.

"The bottom line is alignment among investors, management and boards," McKinley said. "We want to make sure that we have a seat at the table. Not an empty seat," he emphasized.

Activists have already taken aim at a number of companies, nominating slates of alternative candidates. It's up to shareholders to hold those boards' feet to the fire.

At all four, activist hedge funds are proposing slates of director candidates. For most of these firms, share prices have stagnated. With 2007 revenue of $3.2 billion, Brinks, which traded above $65 a year ago, now goes for just under $58.

A hedge fund investor in Sybase is pushing the company to return more cash to shareholders or sell off some assets. And i2 shares have lost 42% of their value over the past year.

Meanwhile, corporate governance strategies are picking up steam across the board. "There will be continued growth in the number of funds that are pursuing this strategy," Junkin said. "You're beginning to see more traditional managers realize that perhaps we can be better stewards of the capital by adopting some of these strategies."